Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

FLEXIBILITY TO LOOK DIFFERENT

Combining all elements of the margin of safety is more important than believing you have a crystal ball. The successful turning points in First Eagle’s investment track record have often been acts of omission: being out of Japan in the late 1980s, being largely out of technology in the late 1990s, and being largely out of financials in 2007 and 2008. As I said earlier, we do not have a crystal ball; we simply could not find enough businesses during those times in those market environments that embodied the valuation margin of safety and had the sustainable earnings power, conservative management behavior, and conservative balance sheet evolution that we demand. Our peripheral vision for macro capital preservation was the sum total of a set of prudent micro acts of omission.

Almost by definition, a passive approach to investing (i.e., mimicking an index) leads to overweighting the sectors that experience the bubbles because it is in those sectors that the greatest expectations for complacency exist in the system. Most managers seek a low tracking error against a benchmark. The whole notion of minimizing risk by minimizing tracking error is a logical non sequitur. The goal of avoiding permanent impairment of capital means that sometimes investors need to stay away from sectors that embody the wrong set of expectations, even if they are the biggest sectors of the market. Most investment managers are not structured to flexibly implement such an approach. ...